Yesterday was a day which saw a meeting of the Federal Open Markets Committee and I will discuss it a little later. The reason why I had not mentioned it before is that I expected no real policy change. We also received some updates on the state of the US economy. One of them retail sales was quite strong with the monthly increase between October and November being 0.8% meaning that the annual rate of increase is now 7.7%. Furthermore retail sales have now recovered back to pre-recession levels so this was a strongish report. In addition November producer prices rose by 0.8% and on an annual basis rose by 3.5%. So the FOMC would have reviewed these figures with a smile, retail sales growth and signs of a small pick-up in headline inflation (remember it thinks that US inflation is too low). As the “core” measure of producer prices rose on an annual basis by only 1.2% and the FOMC emphasises core measures ( a mistake in my view as I have written many times before). it could have its cake almost all ways if it chose! But the underlying theme of the US economy was unchanged and so even on the day we got economic figures implying that the FOMC meeting would not have any policy change.
The FOMC statement
Whilst there was no policy change at the meeting there was a change in some of the language used in the accompanying statement. For those unfamiliar with the process the FOMC produces a statement after each meeting and “Fed-Watchers” examine it closely for nuance and any sign of a prospective change of policy.
There was a reference to the problems in the US housing market where we got this.
The housing sector continues to be depressed.
The reason why this matters is that the last statement only mentioned housing starts so the FOMC is worried about the state of the US housing market and so they should be in my view. I have written before about the forsclosuregate problem and that the market is struggling. The recent rise in mortgage rates will not help going forwards and I will discuss this in a moment. There were also a couple of hints in my view that the FOMC could in future increase its policy actions.
the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment………….measures of underlying inflation have continued to trend downward
As the FOMC sees these as its policy objectives I feel that it is preparing the ground in case further action is required but this is nuance and before then we will have a lot more information on the state of the US economy. As ever there was one dissenter Thomas Hoenig which I raise partly because his tenure on the FOMC is about to end and partly because I admire someone who has the courage of their convictions. One consequence of the end of his tenure is that if you see unanimous votes in future it does not necessarily represent a policy change.
Market Reaction: ten-year yields on US government debt up by one point since the FOMC meeting euphoria
The US Dow Jones industrial average rose by 47 points to 11,476 which is a new high for the year so this aspect of FOMC policy is having a good phase as one of the objectives was a rise in asset prices and we have now had a rise in the Dow of just under 300 points. Going much less well is the plan to reduce longer-term interest rates. In fact this is starting to go very badly. In price terms the US long bond or thirty-year future fell on the day by more than two points continuing recent falls. Its yield is now 4.55% which compares with the November FOMC statement benchmark I established of 3.91% .The situation for the ten-year maturity is even worse as it closed last night at 3.46% compared with my FOMC benchmark of 2.57%. Indeed there is a worse comparison as in the expectations/euphoria around the November FOMC meeting ten-year yields fell briefly to one point below where they are now. This issue must be seriously troubling the FOMC, I know it would trouble me if I was on it.
US Mortgage rates
The corollary of rising longer-term interest rates in the US is that mortgage rates are rising too. If we project forwards the changes that took place ordinary US mortgage rates will be well above 5% and the thirty-year mortgage rate may touch 5%. From the lows of earlier this year this is quite a change and it will have an impact on not only new mortgage borrowing but refinancing/remortgaging too. If you project such a rise into the US housing market and then the impact of a slowing US housing market on the wider US economy then if it should continue ( it appears a solid trend now but markets ebb and flow) it may end up begging the question is QE2 pushing on a piece of string?
On this subject I get challenged on the UK and the fact that for example my argument at the beginning of this year that interest rates needed a nudge higher. It did not take place but my view was for a rise of around 1%. This was for various reasons and the obvious criticism of it as posted in the comments section yesterday is that it would raise some mortgage rates. Part of my reason for believing this back in January was that some now was likely to prevent more later. If we look at the US right now they could hardly be pressing for what is called ZIRP or the zero (short-term) interest rate policy much harder could they? And yet their mortgage rates are rising. In spite of adding 75 billion US dollars of asset purchases a month to policy….
Put another way we are facing a very complex situation in my view where much of conventional economic theory is not working and therefore one sometimes has to be unconventional, more unconventional than central banks have been willing to do. However please feel free to comment if you disagree with me I am only replying to make my point (hopefully) clearer.The quality of the comments is I believe one of the strengths of this blog and there is certainly no compunction to agree with me.
The Euro zone crisis: Belgium
The situation took something of a new turn yesterday with both Spain and more unusually Belgium coming under fire from the ratings agencies. In spite of the credibility problem that the ratings agencies have they do from time to time put their finger on a genuine problem so let me quote from the Standard and Poors statement on Belgium.
If Belgium fails to form a government soon, a downgrade could occur, potentially within six months
This establishes part of the reason why I have mentioned Belgium rarely. Her problems are driven by her politics and I try as much as possible to leave that out of here. Also having dealt with people living there they tell me that political instability and changing coalitions is a permanent state of affairs leading to a degree of ennui. However this has been more pronounced recently and in a time of economic turmoil has led to one or two economic points being asked. For example her fiscal deficit in 2011 is estimated to be 11% of Gross Domestic Product or GDP and her national debt to GDP ratio is around 95%. Added to this she is a country who had to spend a lot of money rebuilding her banking sector. Were she to be located on the Mediterranean I will leave you to draw your own conclusions…… However her political uncertainty at a time of economic problems has begun to worry investors so now even a “core” Euro zone country needs to get its act together, which of course is precisely what it is not doing. Should talk of a split in her between the Germanic Flemish and the less Germanic Walloons go further we might get our own bit of the Med on the Channel coast.
The current rescue system of the European Central Bank buying government bonds would not help much here as if rumours got about that it was supporting a core Euro zone nation like Belgium the situation would deteriorate at a stroke. To quote the Alans Parsons Project ” Damned if you do, damned if you don’t” would be the prospect for the ECB. Also with the disputes in the ECB over this policy there would be the risk of a lot more dissent and even possible resignations at intervention on the scale that would be required. However you look at it last night ten-year Belgian government bonds closed at a yield of 4.08% more than one point over Germany’s. In the heady days following the shock and awe rescue package of early May the spread was more like 0.45%.
There had been a difficult treasury bill auction for Spain yesterday which put markets on the back foot. She had issued both twelve and eighteen month paper but had to pay interest-rates of 3.45% and 3.72% respectively both of which were more than 1% higher than the last time she did so. I have written before that shorter-dated yields are very revealing on the basis that they are the last ones a government loses its grip on. In a bad accident of timing she is issuing some longer-dated paper today and worries about this led to her ten-year yield going to 5.5%.
Accordingly when Moodys rating agency said that it was putting Spain on review for a possible downgrade it probably just about finished off a poor 24 hours in Madrid. Also the reasons behind it were on this occasion mostly things which had been debated on here for some time. for example to say that Spain has a lot of funding to do in 2011 is an odd thing to raise in mid-December 2010! Where have you been Moodys? Is the obvious response to that. In addition the report raised familiar themes (on here) of the cost of recapitalising Spain’s banks being higher than forecast and fears over Spain’s governments ability to control spending in the various regional and local governments (who comprise well over half of Spanish public expenditure). Traders are likely to have greeted this report with the cry “Mafeking has been relieved”, in case you are wondering the siege of Mafeking was lifted in 1900!
Be that as it may such reports do damage even if they could have been written some time ago and part of the reason for this is that Spain is genuinely vulnerable. The bond purchases by the ECB in Ireland and Portugal had also helped stabilise the situation in Spain too but the initial effect had worn off and her yields were rising and prices falling for several days before this. You could if you were so minded accuse Moodys of kicking a nation when it is down.
Moving onto Ireland we get the vote today in her Parliament or Dáil on the bailout from the EU/IMF. There is a big implication from this for me. It is not to recommend that they should vote yes or no but because of the fact that the situation is still unknown and undefined in particular with relation to Ireland’s banking sector one cannot vote rationally in my view. Accordingly they should all abstain until more information is revealed such as the secret side letter about Ireland’s banks. It is my opinion that we are in danger of a yes vote now which is unraveled in 6/12 months time when the full facts are known. That is a worse prospect that finding out all the facts ( as far as one can now).
UK inflation and taxation
I am interested in readers views about the level of UK inflation. I am asking this because in my own expenditure pattern I have seen certain instances of quite considerable rises recently and wonder if I am alone or others have spotted this.
Moving onto the consequences of this I have a thought for you. My brother works as a driving instructor. With the rises in petrol prices which is a big business expense for him his income is reduced but the government via the way it taxes it gains. So in a small way the fiscal deficit is reduced as tax revenue rises but those whose business involves buying fuel have simultaneously inflationary and deflationary forces hitting them.Just to ram it home someone working in these industries has quite a high marginal tax rate if you do the maths. As ever I have and welcome for some people to a 50% tax rate…..But not perhaps for who you expected.